The economic situation in Japan leaves a lot to be desired. There is
substantial under-utilisation of productive resources though it is difficult
to know precisely how large is the output gap. The fiscal situation is
dismal, with public debt rising rapidly and the threat that population
ageing and a clean-up of the financial sector could add to debt build-up.
At the same time, continued deflation in combination with the zero floor
on nominal interest rates prevent real interest rates from providing
necessary stimulus.

Going forward, fiscal consolidation cannot be postponed much longer.
Such consolidation could add further to economic slack and deflationary
impulses. The extent to
which it will do so depends on the degree of Ricardian behaviour by households.
Given the current fiscal situation, some degree of Ricardian behaviour seems
likely but it may not be perfect. And Japan does not seem to have the pre-conditions
that have characterised countries which in the past have enjoyed stimulatory
fiscal contractions. For example, long bond rates are already low and cannot
be lowered much further by any positive confidence effects of fiscal consolidation.

In circumstances where weak supply outstrips even weaker demand and
where fiscal consolidation is likely, if anything, to add to demand
weakness, the question
arises what can be done to boost demand. While weaknesses in the banking
system undoubtedly impair the monetary transmission mechanism, weak
credit growth
is probably mainly a demand phenomenon. Hence, cleaning up the banking sector
is
presumably a necessary component of getting Japan's economy going again but
is unlikely to be a sufficient condition.

In his article "A weaker currency will make Japan stronger"( Financial
Times, 2 April 2003), Kumiharu Shigehara argues that some demand stimulus
could come
from a lower yen exchange rate, though he sees this only as one element
in a comprehensive strategy aimed at restoring Japan's economic fortunes.

A counter-argument against a lower yen in the current circumstances
is that a re-distribution of global demand towards other regions
that already
have
low
inflation and nominal interest rates is a bit of a zero-sum game. However,
this argument should probably not be exaggerated. If combined with unchanged
nominal
interest rates, depreciation in Japan would lead to lower real interest
rates. At the same time, central banks in other parts of the OECD still
have some
margin of manoeuvre for allowing a fall in real interest rates to offset
the demand
effects of an appreciation of their currencies. Hence, a yen depreciation
met with appropriate monetary policy response in other regions would
be associated with some fall in world real interest rates and thereby
be expansionary.
When
that is said, it would obviously have been easier for other central banks
to respond to a substantial yen depreciation some years ago when inflation
and
interest rates were higher.

Mr. Shigehara also suggests that other Asian currencies should move
at least some way in sympathy with the yen. This argument may be
less clear.
Asian
economies are presumably best placed to benefit from any revival in
Japan's domestic
economy consequent on depreciation. And a depreciation of other Asian
currencies vis--vis
the dollar would make it more difficult to prevent an increase in US
real interest rates given the current low level of nominal interest
rates.

Likewise, it is not clear that that it would be productive to enact
a wind-fall tax on profits generated by a large fall in the yen exchange
rate. Even
though it were to be applied, as suggested by Mr. Shigehara, only
to Japan's big,
(super-competitive) companies, such a tax could easily cut off part
of
the investment response to
a lower yen. And the feed-through of higher profits into wage settlements
may also be a healthy inflation-generating mechanism.

While yen depreciation —not diluted through movements in other
Asian currencies and windfall taxes— may provide some helpful stimulus
to the Japanese
economy, the question is whether it is sufficient. This is partly
because other central
banks with already-low policy interest rates may have difficulties
in offsetting the demand impacts of a large yen depreciation, limiting
the
magnitude
of any helpful realignment. But it is also the case that Japan's
is a fairly closed
economy implying that there may be limits to the benefits of a
more modest yen depreciation.

These considerations suggest that it might be useful to at least
consider whether other instruments could be used to boost domestic
demand. Apart
from any re-jigging
of public budgets in the direction of generating larger multiplier
effects of the existing budget deficit, such instruments might
comprise an un-orthodox
use
of the tax system to "artificially" reduce real after-tax interest
rates. Experience from other countries — think of US mortgage
interest relief
or changes in capital
income taxation in the Nordic countries — suggests that
such tax incentives can have non-negligible effects. A tax on
financial
assets combined
with a tax credit
on debt should in principle have some of the same effects as
a fall in nominal interest rates. While the effects are not guaranteed,
Japan may
not be in
situation where one can afford to ignore potentially helpful
policies.

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The writer is a senior official of an international organization.